Ask the grumpies: Inheritance advice

October 25, 2013 — nicoleandmaggie

Miser Mom asks:

How does a young (20-something) person invest a large, sudden inheritance? Let’s say she just got $300K in life insurance, and is expecting a similar amount in the form of the pension/retirement account that comes with the estate.

She is currently unemployed (or at least, employed only in cleaning out her dad’s home and getting it ready to be sold). She’s guessing she might want to semi-retire on this money.

Our condolences on your loss.

The advice that most planners give for people who have just received an inheritance through bereavement is to do nothing with it. Wait. Let it sit in a savings account (or put the bulk in a cd if she think she’ll be tempted by spending sprees) earning very little interest until after she’s done everything she needs to do with finishing up the estate and paperwork and funerals and has gone through a lot of the grieving process.

600K (I’m assuming this is after tax) is not enough for a 20-something to realistically retire on– there’s just too many years of life left, even for someone as frugal as miser-mom(‘s daughter). There’s too many years for (unexpected) negative shocks to happen. Semi-retiring is a possibility if she’s frugal like miser-mom. Of course, when one lives like miser-mom, part-time work probably works as enough of an income stream even without the 600K.

This money does buy the time for her to figure out what she wants to do, to take her time finding the right employment (or to try out different employment options), to explore her interests (even get a masters degree) or to wait for something to come along. It allows freedom and should decrease the stress of unemployment.

Planners generally recommend setting aside a certain amount (anywhere from $500 to 5%) for fun. For travel or charity or something nice. She can certainly do that if she wishes. But she should leave the bulk intact.

My recommendation for what to do with the money after… well, there are a lot of choices.

First, I would pay off all loans, if she has any. Just because. Student loans, car loans, housing loans, etc. Just pay them off.

Second, if she’s planning on staying put, she may want to buy a house. That may or may not be a good idea depending on what housing prices are like where she is, and if she’s planning on staying where she is or if she thinks she might move for other employment. If houses are inexpensive and she’s planning on staying put, go for it. If they’re expensive, or she’s thinking of moving or doing extended travel, then this is probably not something she wants to do. I’m not a financial planner, so I can’t define “expensive”, but I’d worry about buying a house that cost more than 200K without additional employment income to rely on.

Third, set aside a healthy emergency fund (since she’s unemployed and single, 6 months to a year of spending) someplace she can easily access like savings or a CD ladder.

Fourth, I would want to convert the bulk of the remaining money into an income stream. There are many ways of doing this. 1. She can annuitize it, but that’s generally a bad idea for a 20-something since who knows if the company will be in business when she’s 80, so don’t do that. (Annutities make more sense for older folks.) 2. She can put 80-100% of it into the general stock market in a broad-based index from Vanguard. These will spit off quarterly dividends which will be somewhat unpredictable but will have high return and lower risk over a long time horizon (there will be ups and downs). The remainder would go someplace “safe” like bonds, savings, cd ladders, etc. just in case the economy takes another nose-dive. 3. She can turn more of her money into income (but with less growth potential) by investing in dividend-heavy funds like utilities. Vanguard has some dividend-heavy indexes. 4. She can put it all in bonds (this will have a lower return but do a better job of holding the capital) 5. She can put it all in TIPS, which is the most conservative thing she can do. (There are also some riskier options I’m not covering, like lending tree or individual stock investing, but you can read about those on MMM or retireby40. I don’t recommend those options except as “fun” play money.)

Of these options I would lean towards #2 or #3 depending on how much regular income she thinks she’ll need in addition to whatever she brings in once she finds employment. If her employment prospects look good, I would go with #2, which will result in more money in the long run but may have some ups and downs. If she’s less likely to have a steady work income, then #3 will result in less earnings overall, but a steadier stream of income. She can also put up to 20% of what she has someplace save like TIPS or a CD ladder or even savings, just for that emergency buffer should the economy tank again (she could then draw on this fund while she waits for the economy to recover while dividends are down without having to sell stock in a down market).

Once she does find employment, this windfall is not large enough to obviate any need for saving for retirement. She should try to hit 401(k) matches if that’s an option, then IRAs, then the rest of her 401(k).

If she finds she enjoys full-time employment and is getting enough money from her full-time employment to no longer need that income stream from stocks, I would recommend to her to move out of utilities (if she chose option 3) and into broader indexes and to set up DRIPs to increase her investments efficiently. She should also be sure to max out her retirement accounts each year, even if it means converting some of this windfall into retirement savings, to make the most of the tax advantage.

Again, our condolences. And wish her the best of luck with her future endeavors on our behalf.

Grumpeteers, what would you recommend an unemployed 20-something do with a 600K windfall? What would you do with it?

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27 Responses to “Ask the grumpies: Inheritance advice”

I think there are three options:
1) Invest it in traditional vehicles (mutual funds, stocks bonds, college plans), and use to fund spending over the rest of your life:
If she invested it all (with a reasonable allocation), theoretically she could withdraw 3%-4% each year at a steady rate (extra $18,000 in spending money every year forever.)
This is the plain, “I have $600k, and can I retire on that much” answer. (no-unless she thinks she can live on 18k every year for the rest of her life.)
Caveat: This $18,000 is my measure of her maximum extra annual utility from this lump sum. So she could choose to invest it and not touch it for 5 years, deferring some of that 18k per year to use in the future, like saving it in a college fund for kids, but it’s AS IF she was earning an additional $18k per year. I like to show it that way because $600k sounds like a lot, but an extra $18k per year doesn’t, so I think it’s a better way to think about how much it’s truly worth.
2) Invest it in herself
If she wants to invest it in order to have higher income potential in the future:
If she put it into college, like an MBA program, then a couple hundred thousand of that would be gone right away (but no debt, and potential higher future earnings for life). So if you spend $200k on an MBA/law degree/better undergrad degree than already have, you might give up $6,000 per year of your 3% withdrawal rate. But you might get a job that pays $30,000 per year more than you currently earn, and is more fulfilling. But that’s only as long as you stick with the job.
(I have no idea how much MBA’s and law schools cost in total, or if she’d be interested).
Caveat: It’s hard to measure the non-monetary benefits, so I certainly see that it may be worth it for her to go back to school, study something she is passionate about, to enable her to get a job in that field even if it pays less than current job.
3) Spend it on stuff
Spend a year on a luxury travel adventure, donate it to charity, in general, use it for something that you would not otherwise ever buy.

Buying a house is between options 1 and 3 for me, investment, since buying a house with it is kind of an investment, but a house is also a consumable good (in my head). Depends on whether she buys a much more expensive house than she otherwise would “need” to be comfortable.

Paying off student loan debt would also be similar effect to just investing it all (since it will save her paying her $18k income toward interest every year) but the interest savings would be a more solid calculation. If she would pay off those loans over the next 2 years anyway, rather than the 10 years allowed, then the interest she would save by using the inheritance towards it might not be worth it.

I’d forgotten to discuss the draw-down rule, thanks. I worry about withdrawing the principal with her being so young except in emergency situations, because there will be plenty of those in the next 70years, plus the vagaries of the stock market make that difficult over such a long period, especially with this relatively small amount from an early FI standpoint. Obviously right now is an emergency and she should use enough to live on until things settle.

As you say, if she can let it grow for a few decades the drawdown rule will make more sense, but that does mean reinvesting dividends which makes semi retirement more difficult.

I think I disagree about the advice to pay off “all loans”. For sure, any and all high-interest loans should get paid off posthaste – but not necessarily any mortgage or student loans. In our case, we have a very low-interest mortgage and a substantial amount of student loans. We *could* pay all of it off right now and theoretically save money in interest paid; however, we would also lose money earned in investments. Since the interest rate on the loans is substantially less than the average rate of return on our investments, we are not paying off the loans any faster than necessary. This is in accordance with advice given to me by three separate financial planners, although they all included a caveat that if it drives us crazy to have debt we should just pay it off, even though that is not a rational decision.

Also are you sure about still needing to save for retirement? I’m no expert, but if I stick that number in retirement calculators with current age 25 and some sort of median salary expectations, I get the answer that such a person does not need to save any additional money for retirement as long as retirement will be 20 or 30 years away.

My general advice is different from the above, too. A 20-something can *absolutely* live on $18,000 a year. I know because I lived on quite a lot less than that for pretty much my entire twenties. So rather than spend a large part of the principal on something like school or a home, I would suggest that she sock it away in productive investments and take a few years to explore life. There are all kinds of things to do with one’s time that pay very poorly (if at all) but are interesting, fulfilling, and productive nonetheless. Knowing that she doesn’t need to worry about the future at all (and needs to worry about present income only minimally) will free her up magnificently to do these kinds of things, as long as she doesn’t mind living a very basic lifestyle. Then in a few years if she wants to get a graduate degree to do a specific job, or wants to do whatever else, she can.

A further piece of advice that I don’t think anybody said is that she should NOT tell people-in-general about her large net worth. If she does, she will never know if she has real friends or not. In the event of making a formal long-term commitment to a partner, she should tell the partner before any papers are signed, but not much before.

If she wants to semi-retire now, then she won’t be having a very large salary, and she may be living off a lot of this money. If she makes a full salary then either she’s going to spend a lot less than she earns, in which case, why not save for retirement, or she’s going to spend about what she earns in which case she needs to save more for retirement in order to keep her same standard of living.

Also, if she had a steady job right now, I wouldn’t be suggesting to pay off loans without doing a cost-benefit analysis. But with uncertain employment, paying off those loans gives a better idea of what her true net worth actually is so she’s better able to figure out what she can take. She doesn’t have to and she can calculate out the interest rates etc, but if you’re not bringing in any income, having limited required expenditures brings more peace of mind.

Over such a long time period starting the draw-down now, she won’t be getting a steady 18K/year for the rest of time. And there will be some years in which she will need a lot more than 18K/year which will mean she can only pull a lot less than 18K/year in later years. There’s just too much uncertainty. Those calculations work better when someone is closer to the end of needing money.

Obviously I’m not an early retirement expert– she can check out the early retirement forums if she wants. Bogleheads probably has a very good one that will help her think about all the issues. (I’d pick that over MMM where people are more bullish.)

Btw, is that 18K/year inflation-adjusted? (Is it in real dollars or nominal dollars?) In 70 years…

…I’m not trying to be rude, but you’re wrong about that. If the young woman wants to buy a house and settle down to the middle-class lifestyle, she probably does need more than $18K/year (which is a number I just accepted from the first commenter). The greatest income I had in any year in my twenties was around $16K. I worked at seasonal jobs, got volunteer gigs with awesome organizations that provided a stipend and a place to live, took months off at a time, and lived out of a duffel bag. I lived in various charming towns and cities, met lots of great people, and did really interesting things. My life at the time seems in retrospect *far* less limited than the lives of my peers who spent their twenties making middle-class salaries and also paying rent and car insurance (which I generally did not do). But of course it’s all about what one values.

If that is not what the young woman would like to do, then of course my advice is useless. But, being unemployed and somewhat adrift in your twenties can be an unparalleled occasion for adventure. And I was constrained by having to make enough money to eat (sometimes – sometimes I was fed by whatever gig I had lined up), pay my phone bill, and pay my student loans; there were opportunities I had to turn down because I needed to make money. This person would not be constrained by that at all.

To clarify, I’m not suggesting living off $18K a year forever. Just for a while – because it’s easy to do when you’re young.

When I was in my 20s, 18K went a lot further. It also exactly paid the rent+utilities on the tiny crappy university subsidized apartment I shared with my partner in a major city. (Coincidentally it was the amount of my stipend.)

If it isn’t going to be forever, then there’s no reason to be constrained by the 3-4% draw-down rate either. But one does have to be careful, because the money may run out.

This kiddo has no loans, thank goodness. She has a strong college education (double majored in math and classical languages). And she is very frugal (like her mom). She doesn’t drive, and although that might change in the future, her hope is to sell Dad’s home and move to our area, where for about $150k she can buy a really decent place that allows her to walk just about everywhere.

So far, my advice to her has been similar: open a Vanguard index fund, and then move money into it slowly (to take advantage of dollar cost averaging, but also to become comfortable intellectually/emotionally less uncomfortable with the world of investing).

I haven’t yet told her the importance of tracking spending, because she’s not in a stable situation yet. But once things even out, she’ll have a better sense of the extent to which this money will cover her expenses.

Walter Updegrave actually recommends just investing in a lump when you have an inheritance like this. Let me see if I can find that article… I remember being convinced by it at the time (that there were benefits to lump investing in this specific situation over dollar-cost averaging).

One benefit would be that she can just set and forget and collect her dividend checks as she needs them. There’s not much like getting dividend income to make a person feel more comfortable with investing, let me tell you.

Bottom-line: Dollar cost averaging makes a lot of sense when you have smaller amounts of money to dribble into your investment. When you have a large sum to invest you’re losing out on market gains and you’re paying additional fees up front that you don’t have to be paying. Hedge against uncertainty from market timing by buying bonds in addition to stocks instead of dollar-cost averaging.

It’s not an either/or decision either – she could do both lump sum and DCA. I’ve done a mix of both in “windfall years / jobs” and with bonuses etc.
There’s a bunch of threads on this kind of lump sum issue on early-retirement.org as well (or she could join and post the question there) – maybe stay away from the search term “inheritance”, but “windfall” came up with a few good threads.
I’d consider having the house paid off in full and just having a HELOC instead of an emergency fund if after a couple of years, she found herself never dipping into the EF (speaking as someone who never used their EF when they had one).

In all honesty I would recommend that the beneficiary find and consult with a good, paid-by-the-hour financial planner knowledgeable about estates. Not only are these the sorts of decisions that it is possible should not actually be entrusted to the Internets, even these very excellent Internets, it seems likely that there may be important details here that we don’t even know about, or perhaps understand, or even know enough to ask about. For example Miser Mom mentions a “pension/retirement account,” and some of those (depending what kind(s) it is and how it is set up, but I’m no expert!) pass among family members (spouse-to-spouse, if applicable, or parent-to-child, as here) with rules that are distinct from general rules about how such things work. And my understanding is that knowing and applying those rules correctly can yield big (financial and logistical) benefits, while not knowing them and applying them can yield big (relative) losses and hassles. So.

And yeah, once that’s done and within whatever framework/guidelines the advisor recommends, I’d probably be inclined to abide by the “don’t make any major changes for a year” rule and then to explore various options. Given the inheritor’s youth, I’d be more inclined to use the funds to generate gains (increase the principal) than income, contingent of course on the inheritor having a way to support herself in a reasonable manner, and allowing perhaps for some early draw-down in year 1 to smooth over bumps associated with the loss. But then, I’m mostly of a “be kind to your future self” (rather than your current self) planner in this regard, and that may not be the right answer for this person. But hopefully she has decade upon decade of future self to be kind to, and setting herself up to enjoy a long and comfortable (if moderately miserly) dotage seems to me a good goal.

With financial planners, she should be very careful to choose a fee-only one (as you say). Do not go to the local Edward Jones office. Presumably she’s currently working with a lawyer (and possibly an accountant) who is an expert on the inheritance issues; if not, she should be.

All good points. Also, in terms of long-term ROI (once she’s ready/able to think about that), she should consider working at least enough to take advantage of moving some money into tax-sheltered accounts (e.g. the minimum for a Roth, or even possibly a 401K). That is, if she has say $500K from the inheritance outside tax-sheltered accounts, she might want to get a job that pays $22.5K/year (this assumes that she can find a tolerable one, with benefits, both of which may be untrue) and then put $17.5K into the 401K and $5K into the Roth and take a similar amount out of the inheritance as an amount (or part of) to live on for the year. Obviously I’m oversimplifying but hopefully the basic point is clear — having earned income can be useful for allowing one to set up tax-sheltered savings, even if one doesn’t otherwise need or use it.

And what you said, about the rental suggestion, below. Clearly there are people who do this well and find it positive but I would not be one of them.

Exactly re: the moving stuff into retirement accounts– that was some of the point I was trying to make with the partial retirement saving for retirement thing above, but you said it much more clearly and explicitly.

She’s going to need money when she’s older too, so might as well tax-advantage what she can when she can.

Whatever she does, don’t let word get around about the inheritance because people will come up with schemes and requests that strain relationships when you say “No, I’m not interested in investing 100,000 in your new business.” If anyone is rude enough to ask, respond that what little money you received is all tied up.

In addition to a fee only planner, consult a tax professional as well – the fee only planner might not be a tax expert, but likely has one that (s)he will refer you to gladly. But don’t consider the relationship over after the first visit. Keep their cards and consider following up with them for an hour or two once per year for a couple years to make sure you’re still doing everything right. There were a lot of complicated tax issues with inheritances that my MIL had to figure out when her parents died.

Presuming all is equal on the tax side, I’d think about buying a multi-unit property. When you’re in your 20’s you’re still so used to living in apartment buildings that you can live in one and rent out the other 2-4 units. This might be one of the best ways to get “semi-retired” since housing would be covered and she’d be able to have an income from managing the small property that she lives in. Once that’s established, she could probably hand off management to a long-term resident for discounted rent and be free to move elsewhere or do some travel.

With the multi-unit property, be very careful– there’s a lot of things to think about before buying one and just buying one without doing your ROI homework beforehand can result in a big loss in both time and money. (Maybe Mrs. POP can link to some of the POP articles on the topic?) I feel like I read more articles from folks regretting buying investment property than I do from folks happy they made the choice, and the difference isn’t just luck.

Personally I would HATE being a landlord. So there’s that personality match as well– property investment really isn’t passive income.

The numbers are everything. I would not recommend a property of any kind if the numbers don’t give you TONS of wiggle room for a lot of things to fail at once and still come out on top. (I guess that’s my unstated assumption whenever I recommend rentals…)

I think you’re spot on about personality mattering a lot for landlording, especially if you’re going to live on site. You have to walk the line between being friendly enough that they tell you promptly when something is needed on the property, but standoffish enough that they don’t expect you to change the lightbulb if it burns out in your kitchen. Mr PoP calls it “training the renters” since we’re often the first place they’ve ever rented on their own.

There are also psychological issues. If you just pay off loans (not relevant for this person) or buy a house, you might not be as careful with the money as if you slowly pay things off. Also, at that age, she might not know what she wants in a house yet–it’s nice to live in a few places and learn what you absolutely don’t want and which nice things you don’t actually use. Plus with no job yet, she might not even have a clue what sort of lifestyle she will be trying to lead from that house.

Also, before buying house, she needs to know that a paid-off house is not free. There will be maintenance, repairs, insurance, and property taxes. There may be HOA fees. And many homeowners are also tempted to spend a lot renovating, decorating, and just plain filling the house up with furniture.

So, another vote for investing most of it in a diverse low-fee fund and pretend she doesn’t have any money except the dividends. By risking only the dividends, she can take her time learning all that finance stuff she needs to know to make good decisions. Risking only dividends reduces the chances for regret, too.

Also, max out a traditional IRA (to reduce taxes a bit) and, if she has access in time, to a 401K or whatever. Oh, and any good ideas the tax consultant has.

My son (24) is living on the proceeds of a 24000/yr job while he works on his teaching certification. From that, he managed to max out a Roth IRA–thus, he can obviously live on 18,000/yr, while having a lot of fun in New Orleans.

I think your daughter should wait a bit before buying a house. Both my children taught abroad for a year after college, a wonderful experience. But owning a house is a wonderful thing. If she had a roommate or two (she could buy a house that would give her the amount of privacy she requires), she could have many of her housing expenses paid for.

I know many people who live on almost nothing–they have paid off houses, some on family land. If you live in a place with low property taxes, you really don’t need much!

I would counsel her to put 2-3 years of living expenses in the bank/cd/similar, and put the rest in a balanced fund. The dividends will be quite low, so her taxes will be low. If under 26, she can stay on your insurance. Even so, with a low income, she should be eligible for low-cost subsidized health insurance.

To lose a parent so young is terrible, but her dad has given her a wonderful gift.

The 18k thing is a a red herring. If you start a drawdown rule with 60 years to spare, chances are very good that you will end up with much less than that sum. If you argue she’ll work later and bring in income then there is no need to adhere to a drawdown rule.

My deepest condolences. As has been said here already, in her shoes I would have used the funds to pay off all of my loans, and to buy myself a modest house. Most importantly, I’d keep my inheritance a secret.

Long overdue thanks here. The kiddo is still cleaning out her dad’s home, but is just about to make an offer on a home here in my city, about a mile from me. She’ll be able to pay cash for that. Until she cleans out and sells her dad’s home, she’ll be paying the (large) mortgage on that, too. So aside from the two houses, and from opening up a Vanguard account and putting a bit of the money in there, she’ll probably be moving slow with the rest of the money, seeing just how things go during the next year.

There are still (as far as I understand) uncertainties about the part of the inheritance that comes from his retirement accounts. It’s not entirely clear that he listed her as beneficiary, for one thing, and the tax implications will take a while to sort out. Your advice to hire a professional to help with this will be huge.